written by | April 29, 2022

Different Inventory Valuation Methods: What Are They?

Inventory management plays an important role in a company's progress. While running a company, it is important to account for the inventory held by the company at any particular period. We can calculate this with the help of inventory valuation methods. We can use these methods to calculate the total value of inventory owned by a company at a given point in time. Companies calculate this by the sales which have been made in the market.

Did you know?

The extra inventory withheld by the companies at the end of the financial year has to be put to the best use. The inventory stock acts as an asset for the organisation that needs to record a financial value on the balance sheet. This is where applications, like google pay, or google pay credit card, come into help.

The main aim of inventory valuation methods is to determine the inventory turnover ratio and help plan decisions for purchasing accordingly. Let's say you are a car business owner to make it easier. At the end of the financial year, you have 23 cars left that need to get into the balance sheet. This is where inventory valuation methods come in help. You can use this stock or add it to your google pay credit card.

Also Read: Everything You Need to Know about Inventory Costing Methods

The Importance of Inventory Valuation 

One important step of inventory valuation is identifying the unsold items and putting them to the best use. You require a rate that you can multiply by the quantity and arrive at a given final value. There might be the amounts you must have paid for these items throughout the year, so choosing a technique to calculate a standard rate is important.

Let's suppose that there are 23 cars left unsold, but you cannot decide on the final pricing because of the dilemma as to which rate to use. This requires a universal technique and helps you get the best results, and this is where processes like inventory valuation methods come into help.

To make the process easy for you, we have prepared a list of all the pointers to help manage the inventory. This will also tell you which business technique to use for the success of your business.

How is Inventory Valued?

The inventory valuation methods are a great way to utilise the excess supply into something productive and useful. It is like a google pay credit card which acts as an additional money source.

The three most commonly used methods for inventory valuation are:

1. First-In, First-Out (FIFO)

2. Last-In, First-Out (LIFO)

3. Weighted Average Cost

These techniques can also vary from business to business.

First-In, First-Out (FIFO)

This valuation method mainly focuses on keeping the purchasing and manufacturing processes the same. This means that products bought/manufactured first will be sold first at the end of the financial year. According to FIFO, the inventory items are sold in the same way they are purchased from another buyer.

The main aim of this technique is to sell the oldest products first, which is one of the most common ways companies use to sell their inventory. While making a sale from FIFO, subtract the items from the first list of products in which they entered the store or the warehouse.

Example:

Let's say that your business demanded computers bought at different timings and prices according to the fluctuation in the market.

The first purchase was of twenty computers at ₹1,500 each. And the second purchase was made for ten computers at ₹1,700 each. At the end of the financial year, you sold fifteen out of the thirst computers.

If you follow the FIFO inventory valuation methods, the costing will be calculated from the first transaction made when the twenty computers were purchased.

So,

The accounting balance will be (15 computers* ₹1,500 each), which will be ₹22,500.

There are still five computers left from the ₹1,500 purchase and ten from the ₹1,700 purchase. This will commute the total accounting balance of the inventory account as (5*₹1500) (10* ₹1700). The total of this will be ₹24,500.

Last-In, First-Out (LIFO)

This method is opposite to the previous method. The main aim of using this method is to sell the items purchased or manufactured at first. We use the oldest rate purchase number for the oldest order items and the next rate for the remaining items.

This is a lesser-used value evaluation method among companies.

Example:

Let's say that your business demanded computers bought at different timings and prices according to the fluctuation in the market.

The first purchase was of twenty computes at ₹1500 each. And the second purchase was made for ten computers at ₹1700 each. You sold ten out of the thirty computers at the end of the financial year.

After selling eight computers:

The accounting balance will be (8* ₹1700 LIFO Cost) = ₹13600

Now again,

There are twenty computers left from the first purchase, which are costed at ₹1500 each and two computers left from the second purchase, which was costed at ₹1700 each. So;

The balance of the inventory account will come out to be: (20* ₹1500) (2* ₹1700) = ₹33,400

This balance money can be stored as a google pay credit card or used to buy the next set of inventories for your company.

Average Weighed Cost or Average Cost

With this inventory valuation method, the Cost of Goods Sold is calculated by taking the average cost of all the items purchased during a period. This average cost is calculated by dividing the total cost by the number of units that have been purchased during the year.

This method is used by companies that don't show any variations in the inventory.

Example: Let's say that your business demanded computers bought at different timings and prices according to the fluctuation in the market.

The first purchase was of twenty computes at ₹1500 each. And the second purchase was made for ten computers at ₹1700 each. You sold all thirty computers at the end of the financial year so that the total cost will be (20*2500) (10*1700) = ₹67,000. Also, the weighted average cost of this will be ₹67,000 divided by 30= ₹2233.33 per laptop.

But if you make a sale of only 20 laptops,

The accounting balance will come out to be (20* ₹2233.33) = ₹44666.6

Now, the total account balance will be= (10*₹2233.33) = ₹22333.3

Also Read: Know What Is Closing Stock?

Which Inventory Valuation Methods Are the Best for Your Business?

The inventory methods used by the company depend on several factors. One such important contributor is market conditions and how they affect the organisation's financial goals. Listed below are a few scenarios which will help you decide the best inventory valuation method for your company:

1. While Applying Loan for Expansion of Business

Applying for a loan means that you have to keep stocks as collateral. So, you must keep the value of the stocks higher. If the prices increase throughout the financial year, choosing FIFO as the inventory valuation method can help you give higher returns. If the prices are decreasing, then you can select the LIFO technique. This is because the inventory value in your balance sheet contributes to the loan being approved.

2. Attracting Investors and Keeping Them Happy

Companies with high-profit margins tend to get more attention from potential investors. And so, if you are looking for opportunities to broaden your business, then the FIFO evaluation method will be beneficial for your business. Since the profits are comparatively higher in FIFO, it can be the right choice.

3. Saving Taxes

Are you looking for ways to cut down on your tax liability? LIFO evaluation is the best technique to save money in an inflationary situation. The tax liability will be comparatively higher with FIFO. Contrary to that, profit margins will be lower with LIFO.

Conclusion

The inventory valuation methods are a great way to work on the excess inventory and utilise it best. You should choose a technique out of the three most used techniques and employ it in your business. The FIFO method gives a real picture of cost and profitability, and it gives you an accurate picture of the older items and how to use them.

Inventory valuation methods are important as they assist in making a great balance sheet and help meet the overall business growth goals, considering the market conditions. The choice of the method you make can directly impact the business's cost of goods sold. Some other factors to consider while choosing are business location, costs and inventory amount.
Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.

FAQs

Q: What is the inventory system method?

Ans:

The inventory system method is an accounting method where inventory tracking is manually updated at the end of a specific period.

Q: What is the FIFO inventory valuation method?

Ans:

First In, First Out is a valuation method in which the company's assets produced or manufactured are first sold or used.

Q: What are the different methods of inventory valuation?

Ans:

The different inventory valuation methods are FIFO, LIFO and Weighted Average Cost.

Q: What are the best inventory valuation methods?

Ans:

FIFO is considered the best method as it makes the best use of resources.

Q: What are the main inventory valuation methods?

Ans:

First-In, First-Out; Last-In, First-Out and Weighted Average Cost are the main inventory valuation methods.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.